2014 Tax Changes: No More Mortgage Debt Forgiveness Exclusion

Note: On December 19, 2014, Congress retroactively extended the mortgage debt forgiveness exclusion through the end of 2014.  It has expired again as of January 1, 2015.

With 2014 quickly coming to an end, you may be looking at ways to reduce your income tax liability. The first step in any good tax planning is understanding how the law changed from 2013 and how that affects you.

In this series, 2014 Tax Changes, I will give you an overview of the changes in the tax law that may affect you.  If you haven't already, please feel free to read the earlier posts in this series:

• Individual Mandate- discussing the Affordable Care Act's individual mandate that is now in effect;
• Pease Limitation- discussing how your itemized deductions may be limited; and
• Goodbye IRA Charitable Rollovers- discussing the expiration of a special rule that allowed seniors to roll over their IRA's minimum required distributions to a qualified charitable organization without negative tax consequences.

No More Mortgage Debt Forgiveness Exclusion

The general rule in the Internal Revenue Code is that when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This type of income is called "cancellation of indebtedness (COD) income".

While there are several exclusions that could potentially protect taxpayers from having to recognize COD income, one of the most popular was the mortgage debt forgiveness exclusion for individuals who had debt forgiven on their principal residence.  Unfortunately, this exclusion expired at the end of 2013.

As always, please leave your feedback in the comments section below.

Forced to do a Short Sale of Your Home?

In a letter to Senator Barbara Boxer, the IRS took the position that when a California homeowner sells the property through a "short sale" the mortgage will be treated as a non-recourse debt.

I know, you are wondering what that means, let alone if it is in English.

Let me try to break it down for you.

Under the Internal Revenue Code, when you owe someone money and that person forgives the debt, you are treated as having received income equal to the amount of forgiven debt.  This is known as "cancellation of indebtedness (COD) income".

Example:  Jill loans John $20.  A week later Jill tells John that he does not have to repay her the $20.  The IRS considers that $20 income to John because he would not have had it unless there was first a loan and then the loan was forgiven.

Why would a lender, like a bank, forgive your debt?  Typically, it is because the lender is convinced that you are unable to repay it.  In a housing situation, it may be because the house is "under water" and the bank has decided that it makes more financial sense to allow the homeowner to do a short sale (in which the bank approves a sale for less than the mortgage on the property, and forgives the debt on the excess mortgage) than risk having the homeowner stop making mortgage payments and be forced into a foreclosure.

For the past few years, Congress and California had an exception to the normal COD income rules.  The exception was that if the cancellation of indebtedness is for a mortgage on a person's principal residence, the COD income would be excluded from the person's taxes.  However, this exception expired in California on December 31, 2012, and it expired for the federal government on December 31, 2013.

The expiration of this exception was alarming to many.  It meant that not only would people be losing their homes, but they would have to pay the IRS and California significant amounts in taxes in order to lose their homes.  Senator Boxer reacted and sent the IRS a letter asking how it intended to treat California short sales.

The IRS responded (IRS Letter) that because under California law a lender cannot attempt to collect the excess mortgage from the seller in a short sale, the short sale effectively converts the mortgage into a non-recourse debt.

What does all this mean to you?

It means that, in California, a taxpayer who participates in a short sale does not have to recognize "cancellation of indebtedness" income.  The debt is forgiven and there are no adverse tax consequences as a result of the short sale.

California has indicated that they will follow the IRS's position on this issue.

Are you considering doing a short sale of your home?  If so, I would be happy to discuss this more with you.  Just send me an e-mail.

Also, I would be happy to refer you to a great realtor that specializes in short sales.

As always, please leave your feedback in the comments section below.

Update: The IRS has reversed its position and now does require taxpayers to recognize the cancellation of indebtedness income unless they fall into another exclusion.

Selling Your Home?

Are you looking to sell your home?  Then you may be able to take advantage of a major tax benefit!

You may be entitled to exclude $250,000 of gain from the sale of your personal residence.  If you are married, you may be entitled to exclude $500,000 of gain!

In order to exclude this gain, you must meet 3 tests.

1. Ownership Test.   You must have owned the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, either or both spouses can meet this test.
2. Use Test.  You must have used the home as a principal residence for at least 2 of the 5 years prior to the sale.  If married, both spouses must meet this test.
3. Frequency Test.  The exclusion applies to only one sale every 2 years.  If married, this test is not met if either spouse has claimed this exclusion within the past 2 years.

If both spouses do not meet the use and frequency test, then a portion of the exclusion may still be claimed.  In this case, instead of being able to claim the full $500,000 exclusion, the couple would only be able to claim the $250,000 if one spouse meets all 3 tests.

Even if you do not meet these tests, you may be able to claim a reduced exclusion!  A reduced exclusion is available if you sold your principal residence because of:

• A change in your place of employment;
• Health reasons; or
• Unforeseen circumstances.

There is a safe harbor rule defining what qualifies under each of these three exceptions.

Lets look at an example.  In April 2012, John and Jane Smith purchased a small, 2 bedroom house for $500,000.  In September 2013, Jane gave birth to twins and they decided that they needed a larger home to accommodate their larger family.  In October 2013, with the help of a great realtor, the Smiths sold the same house for $800,000.

The Smiths have $300,000 of gain on the sale of their home.  They are afraid they will have to pay taxes on the full $300,000, but they talk to a CPA and learn that they do not have to.  Although they did not meet the 2 year ownership and use tests, they qualified for a reduced exclusion because the birth of multiple children from the same pregnancy is considered an "unforeseen circumstance."  Because they owned and lived in the house for 18 months, they are able to take a reduced exclusion of $375,000 which is enough to eliminate their entire taxable gain.  They do not have to pay any tax on the sale and can use the extra $300,000 to buy a bigger house!

If you are considering selling your home and would like to learn more about this exclusion, please do not hesitate to send me an e-mail.  I would also be happy to talk to you about how having a home office or converting the house into a rental property will affect this exclusion.

Also, I would be happy to refer you to a great San Diego realtor.

As always, please leave your feedback in the comments section below.